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tax notes state
Convergence and Divergence of Global and U.S. Tax Policies
by Karl A. Frieden and Barbara M. Angus
1
product. This work has been conducted under a
mandate from the G-20.2 Moreover, today there
are 139 jurisdictions participating in this effort
through the OECD/G-20 inclusive framework that
together make up over 90 percent of the world’s
3
GDP.
The current OECD-led global tax initiative,
labeled when it began in earnest in 2019 as
“addressing the tax challenges of the
digitalization of the economy,” is one of the most
ambitious international tax undertakings ever,
given its global reach. This latest project builds on
a project initiated in 2013 to address policymaker
concerns that the global tax architecture created
Karl A. Frieden is vice president and general opportunities for base erosion and profit-shifting
counsel for the Council On State Taxation, and
Barbara M. Angus is EY’s global tax policy activity by multinational corporations (MNCs).
leader. Because of that history, the current initiative is
commonly referred to as the BEPS 2.0 project — a
In this article, Frieden and Angus describe
the unprecedented convergence of name that belies the fundamental nature of the
international, federal, and state tax policies changes in the global tax architecture
represented by the OECD/G-20 pillar 1 and 2 contemplated, which would rearrange core
proposals; the importance of approaching U.S. building blocks of the global tax system that were
tax policy from the perspective of aggregate not touched by the original BEPS project. The
federal and state tax impacts; and the potential
risk of divergence between U.S. and global breadth of the project is underscored by a recent
income tax rules that could result in a shift in how the OECD and others refer to the
competitive disadvantage for the United States. project, now describing it as addressing the tax
Copyright 2021 Karl A. Frieden
and Barbara M. Angus.
All rights reserved.
1
The 38 countries in the OECD are Australia, Austria, Belgium,
Introduction Canada, Chile, Colombia, Costa Rica, the Czech Republic, Denmark,
Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Ireland,
The global tax system is on the brink of a Israel, Italy, Japan, Korea, Latvia, Lithuania, Luxembourg, Mexico, the
Netherlands, New Zealand, Norway, Poland, Portugal, Slovakia,
historic change in international tax rules. The Slovenia, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and
OECD has been working for almost a decade on the United States. Costa Rica joined the OECD in May 2021, so it is not
included in any of the OECD statistics in this article. For the OECD GDP,
consensus approaches for changing the rules of see OECD, Gross domestic product (GDP) (indicator) (2021).
international corporate income taxation to adapt 2
The G-20 members are Argentina, Australia, Brazil, Canada, China,
to the changing dynamics of globalization and France, Germany, India, Indonesia, Italy, Japan, the Republic of Korea,
Mexico, Russia, Saudi Arabia, South Africa, Turkey, the United
digitalization. The OECD has 38 members Kingdom, the United States, and the European Union. Together, the G-20
(including the United States) that account for nations comprise roughly two-thirds of the world’s population and 80
percent of global GDP.
about one-half of the world’s gross domestic 3
A list of the inclusive framework member jurisdictions can be found
online.
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5
challenges arising from the globalization and provisions incorporated in U.S. federal tax law in
digitalization of the economy.4 2017 through the Tax Cuts and Jobs Act.
The BEPS 2.0 project includes two parallel Two potential levels of convergence arise in
workstreams. First, pillar 1 continues the connection with the pillar 1 and 2 proposals. First,
consideration of the impact of the growing there is a convergence among the nations that
digitalization of the economy on the effectiveness of have been working together to negotiate these
long-standing international tax concepts that began global tax changes. In this regard, the OECD/G-20
with the original BEPS project. The pillar 1 project prioritizes multilateral consensus and
proposals, if implemented, would transform the coordinated approaches for the taxation of global
existing global tax architecture for a portion of business income over unilateral and nonuniform
global commerce by disregarding the permanent measures. If properly designed and implemented,
establishment (physical presence) standard and convergence in global tax rules could provide
using a formulaic approach to assign a share of benefits for both tax administrators and corporate
taxing rights over global business income to market taxpayers.
countries (where consumers are located). These Second, there is a potential convergence
pillar 1 changes also are intended to result in the between the corporate income taxes imposed at
withdrawal of unilateral measures for addressing the state and federal levels in the United States
digitalization, such as individual country digital and the corporate income taxes of other countries.
services taxes. The pillar 1 proposals do not go as far as U.S. state
Second, pillar 2 expands on the earlier focus on policies in shifting taxing rights to market
reducing profit shifting by seeking to limit low-tax- jurisdictions, but they represent a first global step
rate competition among countries through new in that direction. Similarly, the pillar 2 proposals
global minimum tax rules. The pillar 2 changes, if are not identical to the U.S. international tax
implemented, would supplement the source-based provisions enacted by the TCJA, or to changes to
territorial tax approach used by most of the world’s those rules proposed by the Biden administration,
major economies with a “top-up” tax imposed on but they do follow a parallel approach. Moreover,
foreign income at an agreed minimum tax rate of at the Biden administration’s pending proposals
least 15 percent. Under the proposed global reflect a cross-pollination with the pillar 2 design
minimum tax rules, nations could counter low tax as the former incorporate some elements of the
rates applied by other countries on income earned in latter.
those countries by imposing an immediate The support of the Biden administration for
additional tax on that income to yield a combined both pillars 1 and 2 has fueled new momentum for
tax at the agreed minimum rate. the project during 2021. With pillar 1, the Biden
The bold changes in international tax rules administration has backed the overall approach of
under consideration by jurisdictions in the OECD/ implementing new nexus and profit allocation
G-20 inclusive framework are broadly modeled rules expanding the taxing rights of market
on corporate income tax policies already in place jurisdictions but has urged a change in the scope
at the state and federal levels in the United States. of businesses subject to the new rules that moves
The pillar 1 proposals bear strong resemblance to farther away from the original digital focus. With
the economic nexus standards and market pillar 2, the Biden administration has strongly
sourcing rules incorporated in U.S. state corporate supported the global minimum tax rules but has
income taxes, in many cases decades ago. The encouraged the adoption of a minimum rate
pillar 2 proposals rely heavily on concepts higher than had been the focus of discussion
underlying the so-called GILTI and BEAT before this year.
Part 1 of this article discusses the emerging
consensus on pillars 1 and 2, the roots of these
5
4
The global intangible low-taxed income rules are in IRC sections 250
OECD, “OECD Secretary-General Tax Report to G20 Finance and 951A, and the base erosion and antiabuse tax rules are in IRC section
Ministers and Central Bank Governors” (July 2021). 59A.
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proposals in U.S. state and federal precedents, 2021 on the Biden administration’s tax legislative
and the connections between the global and U.S. proposals, it is likely that if any of the proposed
approaches. The OECD/G-20 project is at a critical changes to GILTI and other international tax
juncture. In meetings held in late June and early provisions are enacted, those changes would take
July, members of the inclusive framework reached effect well in advance of pillar 2 legislation in
agreement on key components of both pillars 1 other nations.
and 2, and the G-20 finance ministers endorsed In Part 2 of this article, we evaluate some of the
that conceptual agreement. The aim now is to risk factors through the prism of the aggregate U.S.
finalize the agreement by October, when the G-20 federal and state tax system as applied to global
finance ministers will meet midmonth and the business income. This is particularly important
G-20 leaders will gather for their annual summit given both the uniquely large state and local
at the end of the month. While substantial work government share of all taxes in the United States
must still be done, at this point, all indications are and the shortcomings of treating federal and state
that a final agreement will be announced before taxes as two separate and disconnected spheres. A
year-end. Then attention will turn to minority of other countries have strong
implementation of the agreement, which will subnational government tax systems, but the
require substantial changes in national tax laws United States is one of only two OECD or G-20
and tax treaties and will likely take several years nations with both significant state corporate
or longer. income and sales tax systems, one of only three
The emerging global convergence on OECD nations where state and local governments
fundamental changes to the architecture for account for one-third or more of all government
taxing global business income modeled roughly revenues, the only country with a DST at the
on U.S. precedents, however, should not obscure subnational level, and the only country without a
signs that a significant divergence could develop broad-based consumption tax at the national level.
between U.S. and global income tax rules. Until When U.S. federal and state tax systems are
recently, the United States was a more skeptical viewed as one integrated fiscal system, the risks of
participant in the OECD/G-20 BEPS 2.0 project. the United States ending up outside global tax
There has been concern that a central outcome of norms become more apparent. Among the fault
the project would be increased foreign taxes on lines focused on in Part 2 are the potential that the
U.S. MNCs, particularly on digital businesses. United States could leapfrog other advanced
The United States also has its own unique blend of nations and adopt a higher combined federal/state
federal and state taxation that skews how global tax rate on domestic corporate income and
tax proposals translate to the United States. distributions; adopt a higher combined federal/
Finally, the Biden administration is adding state minimum tax rate and broader tax base
another level of complexity to the mix with its relating to the foreign income of U.S. MNCs than
parallel but distinct goal of increasing U.S. taxes other countries apply to their MNCs; and
on the domestic and foreign earnings of U.S. unilaterally impose DSTs at the subnational level
businesses to reverse some of the TCJA tax while other countries remove DSTs at the national
reductions and to pay for ambitious federal level.
infrastructure and social spending programs. The The potential for tax rate disparity is reinforced
administration’s tax proposals will be considered by the unique composition of taxes in the United
in Congress this year as part of the ongoing work States. As the only country in the world without a
on a budget reconciliation bill. general consumption tax at the national level, the
These factors combine to create an United States is dependent on income and social
environment in which the United States may insurance taxes to pay for new federal programs or
adopt corporate tax rates and policies that are out reduce federal debt. The design of the U.S. tax
of sync with prevailing international norms, system, without significant structural change,
thereby undermining the stability and global makes it very likely that income tax rate disparity
competitiveness of the U.S. tax system. Indeed, with other countries will increase in the future.
given the potential for congressional action in
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Our goal in this article is not to take a position The OECD issued its BEPS action plan in June
on the optimal U.S. corporate income tax rates on 2013, outlining 15 action areas, including action 1
domestic or foreign-source income, or to provide on addressing the tax challenges of the digital
a critique of all the elements of the OECD/G-20 economy; action 3 on strengthening controlled
pillar 1 and 2 proposals or the Biden foreign company rules; action 5 on countering
administration’s U.S. tax proposals. There are harmful tax practices of countries; action 7 on
significant policy choices to be made by the preventing the artificial avoidance of PE status;
United States and other countries on how best to and actions 8-10 on assuring that transfer pricing
7
adapt and reform their tax systems to provide a outcomes are in line with value creation. With the
level playing field while at the same time action plan, the OECD began a process for
responding to tax challenges arising from the including the G-20 countries in the work on the
globalization and digitalization of the economy. BEPS project and set a timeline for completing
But we believe it is important to evaluate the work by the end of 2015.
impact of emerging global tax policies on the Over the next two years, the work on the BEPS
capacity of the United States to maintain a project proceeded with the OECD issuing
balanced and competitive tax system. Generally, numerous discussion drafts and holding public
governments can choose among taxes based on consultations, culminating with the issuance of
when money is spent (consumption taxes), when final reports on all 15 actions in October 2015. The
money is earned (income and social insurance measures agreed upon ranged from minimum
taxes), and the value of assets (property- and standards, which all participating countries
capital-based taxes). A balanced tax system relies committed to implement, to a variety of non-
on a mix of revenue sources that meet key policy mandatory measures in the form of revisions to
objectives such as equity, economic growth, existing standards, common approaches, and
transparency, ability to pay, and stability. A guidance on leading practices, which were aimed
competitive tax system uses income tax rules that at providing support to countries and facilitating
achieve parity or near parity with the income convergence of national practices.8
taxes imposed by other advanced nations on their The inclusive framework was created by the
own MNCs. G-20 and OECD in 2016 to continue the work on
the BEPS project with the involvement of other
Background: From the Original BEPS Project to interested jurisdictions, including developing
The Current BEPS 2.0 Project countries. Membership in the inclusive
To put the BEPS 2.0 proposals in context, it is framework requires a commitment to the
useful to look at how the entire BEPS project has comprehensive BEPS package.
evolved. The first OECD report on BEPS was Regarding action 1 on addressing the tax
issued in February 2013, with the support of the challenges of the digital economy, the 2015 final
6
G-20. The 2013 report provides an overview of report concluded that “the digital economy
global developments affecting corporate taxation cannot be ring-fenced as it is increasingly the
9
and reviews key principles that underlie the economy itself.” Several options to address the
taxation of cross-border activities and the BEPS broader challenges of the digital economy were
opportunities these principles may create. The considered (including new nexus in the form of
2013 report indicates the OECD’s intention to significant economic presence), but none were
draft an action plan to develop measures to recommended in the report, in part because it was
address key BEPS pressure areas. expected that the other BEPS measures would
7
OECD, “Action Plan on Base Erosion and Profit Shifting” (2013).
8
OECD, “Explanatory Statement” (2015). Since 2015 many of the
6 agreed measures have been implemented by countries around the
OECD, “Addressing Base Erosion and Profit Shifting” (2013). See also
world, including anti-hybrid rules, limitations on interest deductions,
G-20 Finance Ministers Meeting Communiqué (Nov. 5-6, 2012) (“We also
changes in transfer pricing rules related to intangible property, and CbC
welcome the work that the OECD is undertaking into the problem of
reporting requirements.
base erosion and profit shifting and look forward to a report about 9
progress of the work at our next meeting.”). Id. at 13.
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have a substantial impact on issues that had been progress on pillar 2. In October 2020 the OECD
identified in the digital economy. The G-20 and released detailed blueprints for the two pillars,
14
OECD agreed to monitor developments in the totaling almost 500 pages. While the content of
digital economy and to make a determination, the blueprints was not fully agreed upon, the
based on a broad look at the ability of existing inclusive framework jurisdictions approved their
international tax standards to deal with tax public release and indicated that they viewed the
15
challenges raised by developments in the digital blueprints as a solid basis for future agreement.
economy, as to whether further work on options Both blueprints identify open issues and
10
in this area should be carried out. additional work to be done. The OECD issued a
The inclusive framework jurisdictions consultation document on the two blueprints and
continued their work and in January 2019 agreed received more than 250 comment submissions
to examine and develop, on a without-prejudice from stakeholders.
basis, proposals regarding profit allocation and Following the U.S. election in November 2020,
11
nexus rules and new global minimum tax rules. there has been significant political-level focus on
Following a public consultation seeking input the project aimed at resolving key differences
from stakeholders on proposals to be examined among countries. The Biden administration has
under the two pillars, the inclusive framework expressed strong support, though it is seeking
16
jurisdictions in May 2019 agreed on a work changes to both pillars. During their June
program for both pillars with an ambitious meeting, the G-7 finance ministers reached
12
timeline for completion by the end of 2020. agreement on several elements, providing further
17
In January 2020, following public momentum for the project.
consultations on both pillars, the inclusive At the conclusion of two days of meetings of
framework jurisdictions agreed on an outline of the inclusive framework jurisdictions, the OECD
the architecture for pillar 1 and welcomed
13
OECD, “Statement by the OECD/G20 Inclusive Framework on
BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising
From the Digitalisation of the Economy,” (Jan. 31, 2020). The inclusive
framework statement also identified critical policy differences, including
a U.S. proposal to implement pillar 1 on a “safe harbor basis” that raised
concerns for many countries, as well as significant divergences of view
on dispute prevention and resolution mechanisms, the amount of profit
to be reallocated to market jurisdictions, and the continued application
of DSTs. Also, it noted that more technical work was required. Political
10 challenges continued during 2020, combined with the practical
In March 2018 the OECD issued a report on developments challenges of moving to all-virtual meetings as a result of the COVID-19
regarding the digitalization of the economy, discussing value creation pandemic.
across different digital business models, providing an overview of tax 14
policy developments relevant to digitalization, and describing OECD, “Tax Challenges Arising From Digitalisation — Report on
challenges identified regarding the continuing effectiveness of Pillar One Blueprint: Inclusive Framework on BEPS” (2020). OECD, “Tax
international tax standards in light of digitalization. The report makes Challenges Arising From Digitalisation — Report on Pillar Two
clear that at the time of its issuance, a significant divergence of views Blueprint: Inclusive Framework on BEPS” (2020).
15
existed among participating countries on the need for any future OECD/G-20 inclusive framework on BEPS, “Cover Statement by
changes in the international tax system to address digitalization. OECD, the Inclusive Framework on the Reports on the Blueprints of Pillar One
“Tax Challenges Arising from Digitalisation — Interim Report 2018: and Pillar Two” (Oct. 8-9, 2020).
Inclusive Framework on BEPS” (2018). 16
11
The Biden administration also made clear that it would not pursue
OECD, “Addressing the Tax Challenges of the Digitalisation of the the safe-harbor approach to pillar 1 that had been proposed by the
Economy — Policy Note” (Jan. 23, 2019). Trump administration.
12 17
OECD, “Addressing the Tax Challenges of the Digitalisation of the G-7 Finance Ministers & Central Bank Governors Communiqué
Economy,” (Feb. 12-Mar. 6, 2019). OECD, “Programme of Work to (June 5, 2021) (“We strongly support the efforts underway through the
Develop a Consensus Solution to the Tax Challenges Arising From the OECD/G20 Inclusive Framework to address the tax challenges arising
Digitalisation of the Economy” (2019) (“A growing number of from globalisation and the digitalisation of the economy and to adopt a
jurisdictions are not content with the taxation outcomes produced by the global minimum tax. We commit to reaching an equitable solution on the
current international tax system, and have or are seeking to impose allocation of taxing rights, with market countries awarded taxing rights
various measures or interpretations of the current rules that risk on at least 20 percent of profit exceeding a 10 percent margin for the
significantly increasing compliance burdens, double taxation and largest and most profitable multinational enterprises. We will provide
uncertainty. . . . Cognisant that predictability and stability are for appropriate coordination between the application of the new
fundamental building blocks of global economic growth, the Inclusive international tax rules and the removal of all Digital Services Taxes, and
Framework is therefore concerned that a proliferation of uncoordinated other relevant similar measures, on all companies. We also commit to a
and unilateral actions would not only undermine the relevance and global minimum tax of at least 15 percent on a country by country basis.
sustainability of the international framework for the taxation of cross- We agree on the importance of progressing agreement in parallel on both
border business activities, but will also more broadly adversely impact Pillars and look forward to reaching an agreement at the July meeting of
global investments and growth.”). Id. at 7. G20 Finance Ministers and Central Bank Governors.”).
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on July 1 released a conceptual agreement that has in the OECD transfer pricing guidelines. Both of
support from 133 of the 139 inclusive framework these standards are also enshrined in U.S. federal
18
jurisdictions. The conceptual agreement covers tax law and U.S. bilateral tax treaties.
key components of the two pillars and indicates The PE requirement confers taxing rights if a
the intention to finalize the agreement in October corporation has a fixed place of business, such as
together with a detailed implementation plan. At a factory, office, warehouse, or place of
their July 9-10 meeting, the G-20 finance ministers management, in the taxing jurisdiction. The arm’s-
endorsed the July 2021 agreement and the plans length principle relies heavily on rules that align
19
for finalization. the distribution of taxing rights with the physical
Final agreement of the inclusive framework location of value-creating (income-producing)
jurisdictions, if achieved, represents only the end activities, not the location of the customer or the
of the beginning. The next phase of the project market.
involves action at the individual country level to The pillar 1 proposals would make
implement agreed rules under pillars 1 and 2 fundamental changes to these long-standing
through changes in their domestic tax laws and cornerstones of the global international tax
treaty agreements. There is no historical architecture. The centerpiece of pillar 1 is a new
precedent for global coordination on tax matters set of rules aimed at increasing the share of profits
of this magnitude and complexity. While the path of a global MNC that is allocated to the
and timeline for the implementation process jurisdictions where its customers are located,
remain to be seen, the significant political interest regardless of whether the MNC has a physical
in these global tax changes is expected to continue presence in those market jurisdictions. Pillar 1
to drive activity around the world. would require extensive coordination and
cooperation among tax authorities, not just in the
Part 1: The Convergence of Global, Federal, and implementation of the new rules, but in the
State Tax Policies ongoing application of the rules to global MNCs.
Overview of Pillar 1 — Revisions to Long- The Design and Scope of Pillar 1
Standing Nexus and Profit Allocation Rules At the center of pillar 1 is a new approach to
dividing taxing rights among jurisdictions
The OECD has long been the global champion
regarding global businesses in scope that would
and protector of the PE standard for determining
find nexus without physical presence and would
taxable nexus, which is embodied in the OECD
20 apply a formulaic approach for reallocating a
model tax convention, and the arm’s-length
portion of profits to market jurisdictions. This
principle for allocating profits, which is embodied
formulaic allocation is largely independent of the
allocations under traditional PE and transfer
pricing analysis that generally assign taxing rights
18 to the location of value-creating activities. The
OECD/G-20 Base Erosion and Profit Shifting Project, “Statement on
a Two-Pillar Solution to Address the Tax Challenges Arising From the pillar 1 blueprint released in October 2020 refers
Digitalisation of the Economy” (July 1, 2021). The six inclusive to the taxing rights that would be gained by
framework jurisdictions that had not joined the agreement as of August
12, 2021, are Estonia, Hungary, Ireland, Kenya, Nigeria, and Sri Lanka. market jurisdictions under this approach as
19
Italian G-20 Presidency, Third Finance Ministers and Central Bank “Amount A.”
Governors Meeting, Communiqué (July 9-10, 2021) (“After many years
of discussions and building on the progress made last year, we have The pillar 1 blueprint also includes a separate
achieved a historic agreement on a more stable and fairer international set of new rules that would provide a fixed return
tax architecture. We endorse the key components of the two pillars on
the reallocation of profits of multinational enterprises and an effective on specified baseline marketing and distribution
global minimum tax as set out in the ‘Statement on a two-pillar solution activities in the market jurisdiction (referred to as
to address the tax challenges arising from the digitalisation of the
economy’ released by the OECD/G-20 Inclusive Framework on Base “Amount B”). These rules would apply only
Erosion and Profit Shifting (BEPS) on July 1. We call on the OECD/G-20 where a global business has a traditional PE in the
Inclusive Framework on BEPS to swiftly address the remaining issues
and finalise the design elements within the agreed framework together
with a detailed plan for the implementation of the two pillars by our
next meeting in October.”).
20 21
OECD, “Model Tax Convention on Income and on Capital: OECD, “OECD Transfer Pricing Guidelines for Multinational
Condensed Version” (2017). Enterprises and Tax Administrations” (2017).
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market jurisdiction and are intended to eliminate that are provided over the internet or an electronic
a common source of disputes between taxpayers network with minimal human involvement.
and tax authorities by providing a formulaic Consumer-facing businesses were defined as
determination of the return for limited-risk businesses that generate revenue from the sale of
distributors. The July 2021 agreement of inclusive goods or services of a type commonly sold to
framework jurisdictions describes Amount B as consumers, including those selling indirectly
involving the application of the traditional arm’s- through intermediaries or by way of franchising or
length principle to in-country baseline marketing licensing. The blueprint provided exclusions from
and distribution activities on a simplified and scope for specific industries, including natural
streamlined basis, taking into account the needs resources, financial services, construction, and
of low-capacity (under-resourced) countries. It international transportation.
indicates that the work on Amount B will be In April U.S. Treasury representatives
completed by the end of 2022. presented to the inclusive framework a proposal
From the outset of the pillar 1 discussions, the for a completely different approach to defining
question of what businesses to include within scope the businesses within scope of the new nexus and
of the proposed new approach to nexus and profit profit allocation rules, proposing to replace the
allocation has been contentious. Many countries, qualitative tests reflected in the pillar 1 blueprint
including the United Kingdom most vocally, with a purely quantitative test based on revenue
favored limiting the new rules to digital businesses. and profitability. This approach was described as
The United States objected to a digital-only eliminating the potential for subjectivity in
approach, asserting that digital businesses could not application of the business activity tests. The U.S.
and should not be singled out for special tax Treasury outlined the intention that the revenue
treatment and advocating for the application of the and profitability thresholds include in scope “the
new rules to other businesses when traditional largest and most profitable” MNC groups
profit allocation approaches may not assign without regard to industry or business model,
sufficient value to the market location. The U.S. with the objective of having the rules apply to “up
22
opposition to any attempt to ring-fence digital to 100” MNCs.
business activity was first communicated by the This proposal for a quantitative approach to
Obama administration in the original BEPS project, scoping generated significant interest among
and it has continued into the BEPS 2.0 project inclusive framework jurisdictions, although some
through the Trump administration and now the countries initially expressed concern that it shifted
Biden administration. away from the original aim of addressing
The pillar 1 blueprint defined scope using digitalization. Subsequent discussions focused on
revenue-based thresholds designed to capture large how to set the quantitative thresholds to ensure that
MNCs with significant global activity, combined global MNCs of particular interest to some countries
with business activity tests designed to capture are captured within scope. Also, extensive
MNCs that participate in a sustained and significant negotiations have taken place among countries
manner in the economic life of a market jurisdiction regarding potential industry-based exclusions.
without necessarily creating a commensurate level Following the G-7 finance ministers’
of taxable presence in the market under existing endorsement of applying the new nexus and
global international tax rules. Under the threshold profit allocation rules to the largest and most
tests, the new rules would apply only to MNCs with profitable companies, the July 2021 agreement
annual consolidated revenues of at least €750 reflects the quantitative threshold approach,
million, which is the threshold for application of the
country-by-country reporting requirement
developed in the original BEPS project.
The business activity tests described in the pillar
1 blueprint covered two categories: automated 22
U.S. Treasury presentation to the steering group of the inclusive
digital services and consumer-facing businesses. framework, quoted in Stephanie Soong Johnston, “U.S. Offers Key to
Automated digital services encompassed services Unlock Scope Issue in Global Tax Reform Talks,” Tax Notes Int’l, Apr. 12,
2021, p. 147-149.
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specifying that MNCs with global revenue of out mechanism, reducing future profits subject to
more than €20 billion and profitability of more the new allocation.
than 10 percent would be in scope of the new The pillar 1 blueprint describes a three-step
23
rules. The agreement further specifies that the process for allocating a portion of profits to a
extractive and regulated financial services market jurisdiction, and the July 2021 agreement
24
industries would be excluded. It also describes fills in parameters for the first two steps. First, a
the potential for reducing the revenue threshold profitability threshold would be applied, with
to €10 billion in the future, contingent on only profits in excess of 10 percent of revenue
successful implementation of the new rules as (referred to as residual profits) subject to
determined based on a review to begin seven reallocation. Second, a reallocation percentage of
years after the agreement comes into force and be between 20 and 30 percent would be applied to
completed within a year. determine the share of such residual profits to be
Two Key Changes in Foundational Principles: allocated to market jurisdictions.25 Third, a
Economic Nexus and Formulaic Market revenue-based allocation key would be applied to
Allocation determine how this profit amount is divided
among market jurisdictions with nexus. To
The pillar 1 blueprint provides that the new
illustrate the application of these parameters, an
nexus rules would apply only for purposes of the
MNC with total profits of 25 percent of revenue
new allocation of taxing rights to market
would be considered to have residual profit of 15
jurisdictions and are not intended to apply for any
percent of revenue (the excess of 25 percent over
other tax or nontax purpose. The July 2021
the threshold of 10 percent), and profit of 3 to 4.5
agreement provides a special-purpose nexus rule
percent of revenue (20 to 30 percent of the 15
based on revenue alone. Under this economic nexus
percent residual profit) would be subject to
approach, an in-scope MNC is considered to have
allocation among the market jurisdictions with
nexus in a market country if it derives at least €1
nexus.
million in revenue there. A lower threshold of
The July 2021 agreement specifies that the group
€250,000 would apply in the case of countries with
entity or entities that would bear the new tax
GDP below €40 billion. The agreement further
liability to market jurisdictions would be drawn
provides that revenue would be sourced to the end-
from those entities that earn profit above 10 percent.
market country where goods or services are used or
The agreement reiterates that double taxation of the
consumed. Detailed source rules for particular
profits allocated to market jurisdiction would be
categories of transactions will be developed, with
relieved using either the exemption or credit
MNCs required to use a reliable method based on
method.
their own facts and circumstances.
Given the importance of tax certainty to
As described in the pillar 1 blueprint and
businesses and tax authorities alike, the pillar 1
reiterated in the July 2021 agreement, once nexus is
blueprint describes a multi-step dispute prevention
established, the new profit allocation rules would be
process regarding application of the new nexus and
applied on the basis of groupwide (or, when
profit allocation rules. The July 2021 agreement
relevant, segment) profits, measured based on profit
specifies that in-scope MNCs would benefit from
before tax determined under financial accounting
dispute prevention and resolution mechanisms for
standards with limited adjustments. For this
all aspects of the new nexus and profit allocation
purpose, losses are carried forward through an earn-
rules in a mandatory and binding manner.
However, it further notes that consideration will be
given to providing only an elective dispute
23
In this regard, the July 2021 agreement provides that segmentation resolution mechanism for specific developing
would be applied in exceptional circumstances, when a segment economies.
disclosed in the MNC’s financial accounts would meet the scope rules on
a stand-alone basis. This would bring such a segment in scope even if the
MNC as a whole does not meet the scope thresholds.
24
One recent analysis estimates that 78 MNCs would fall within this 25
scope definition. Michael Devereux and Martin Simmler, “Who Will Pay Note that the precise reallocation percentage applicable to the
Amount A?” Oxford University Centre for Business Taxation (July 2, deemed residual profit amount is an open question that remains to be
2021). addressed in the final agreement expected in October 2021.
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Removal of Individual Country DSTs coordination question. The meeting communiqué
The pillar 1 blueprint provides that a necessary expresses the intention to provide for appropriate
element of a consensus agreement is commitment to coordination between the application of the new
the removal of “relevant unilateral measures” put in international tax rules developed under pillar 1
place by jurisdictions to address the same concerns and the removal of all DSTs and other relevant
that would be addressed on a coordinated basis similar measures on all companies. The July 2021
under the new pillar 1 rules. From the outset of the agreement reiterates this intention. Thus, removal
project, the United States has insisted that this will of DSTs is not required based on a final agreement
require elimination of countries’ DSTs. under pillar 1, but only when the new nexus and
The concept of a DST was originally developed profit allocation rules have been implemented
by the European Commission as a temporary and are applicable. At that time, removal of DSTs
measure to be used only until the global architecture is required not just for those MNCs that are within
27
for applying corporate income tax could be adapted scope of the pillar 1 rules, but for all companies.
to provide taxing rights over profits to the countries U.S. State Tax Precedents for Pillar 1
where markets are served through digital means. The pillar 1 shift to economic nexus and
The objective of pillar 1 is to reach a consensus formulaic market allocation would apply not to all
agreement on new nexus and profit allocation rules, revenue streams, but only to a portion of the
thus adapting the global income tax architecture deemed residual profit of the largest and most
and thereby fending off uncoordinated action profitable MNCs that are within the scope of pillar 1.
through unilateral DSTs. The ambitious timelines set Nevertheless, the pillar 1 changes represent a radical
for the BEPS 2.0 project when it began in early 2019 departure from the long-standing global tax
were driven by the pressure of country interest in architecture. To date, no country has widely
DSTs. incorporated these two concepts into its corporate
Notwithstanding the ongoing work on pillar income tax laws.
1, France became the first country to enact a DST There is, however, a long-standing precedent
in July 2019, with the tax applicable back to the for using both economic presence and formulary
beginning of 2019. This was followed by apportionment rules for taxing cross-border
enactment of DSTs in the United Kingdom and commerce. The U.S. states — alone among
other countries in Europe and beyond. DST national and subnational tax systems in the world
legislation now has been enacted in numerous — incorporated these principles into their
countries around the world, with other countries corporate income tax systems, in many cases
26
actively considering putting such rules in place. 28
decades ago. All but one of the U.S. states with
Some, but not all, of these DSTs include sunset corporate income taxes require, or at least do not
clauses tied to new pillar 1 rules. preclude, the use of an economic nexus standard
The growing number of DSTs around the for determining the jurisdictions with taxing
world has further complicated the inclusive rights over businesses.29 Similarly, all the states
framework discussions under pillar 1, requiring with corporate income taxes use formulaic market
consideration of how removal of DSTs should be
coordinated with the new nexus and profit
allocation rules. With the United States, France, 27
and the United Kingdom at the center of the It is not clear how broadly the removal requirement will extend to
other forms of digital taxation beyond DSTs.
dispute over DSTs, the agreement reached by the 28
See generally Karl A. Frieden and Stephanie T. Do, “State Adoption
G-7 finance ministers at their June meeting of European DSTs: Misguided and Unnecessary,” Tax Notes State, May
10, 2021, p. 577.
represents a significant breakthrough on this 29
With the exception of Delaware, all states with a corporate income tax
(and the District of Columbia) have broad nexus statutes with no explicit
physical presence requirement or have economic nexus standards through
the application of bright-line factor nexus standards (based on Council On
26
State Taxation research). For corporate income tax purposes, states are still
Countries that have enacted DST legislation include Austria, preempted by the federal protections in P.L. 86-272 from imposing an
France, Italy, Kenya, Sierra Leone, Spain, Tunisia, Turkey, and the United income tax return filing responsibility on a business that sells tangible
Kingdom. Countries have also put in place other unilateral measures personal property and whose only physical presence in the state relates to
aimed at taxing digital activity, including digital PE, VAT, and the solicitation of sales. Those federal protections are not afforded to
equalization levy rules. (Based on EY research.) companies selling services or licensing intangible property.
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sourcing to some degree, and two-thirds of the Initially, when most commerce occurred in one
states rely exclusively on market sourcing for the jurisdiction, differences between international and
30
allocation of income to the states. state tax principles were less obvious. But over time,
The Historical Evolution of State Corporate as cross-border trade expanded and services,
Income Tax Principles intangibles, and eventually digital commerce have
grown in importance, the split in approaches has led
State corporate income taxes have followed a to greater adaptability of state tax rules to new
very different historical trajectory than similar business models. States have been able to broadly
national corporate income taxes. The introduction tax service and digital-based businesses without the
of state corporate income taxes in the United States constraints of PE rules and value-creating-activity
in the second and third decades of the 20th century allocation methods.
piggybacked on the enactment of the federal
income tax in 1913.31 Over the course of their 100- The Early Adoption of State Allocation of Taxing
year existence, state corporate income taxes have Rights to Market Jurisdictions
largely conformed to federal income taxes for The first of the two principles that emerged at
purposes of determining the types of income and the state level was market sourcing. Nearly 75
deductions included in the tax base. But states have years ago, states developed a system for
never linked explicitly to two of the key federal and apportioning income between jurisdictions that,
global principles: (1) the PE standard used by the from the outset, included assigning at least one-
United States and other nations to determine the third of taxing rights to the market state. The
jurisdiction to tax; and (2) the rules used to allocate National Conference of Commissioners on
income based on the locations of value-creating Uniform State Laws (now the Uniform Law
activities and not the place of consumption.32 Commission) promulgated the Uniform Division
These deviations are partially attributable to of Income for Tax Purposes Act in 1957. UDITPA
states not being signatories to, nor bound by, U.S. endorsed an equally weighted three-factor
treaties with foreign nations — primarily driven apportionment formula based on property, payroll,
34
by the impracticality of involving states in and sales. The sales factor in the formula —
international agreements.33 But they are also the originally designed to attribute income to states in
result of a nearly 75-year evolution of state which goods are consumed (destination-based) —
jurisdiction and apportionment rules to adapt to served as a counterbalance to the property and
the changing dynamics of interstate and global payroll factors, which focused on where the goods
commerce. State income tax laws have inexorably were produced. UDITPA’s three-factor
moved away from predicating jurisdiction to tax apportionment method was incorporated into the
on physical presence and assigning value based Multistate Tax Commission’s Multistate Tax
on a taxpayer’s income-producing activities and Compact in 1967.35 This formula constituted a
toward a much more significant reliance on dramatic change from global norms, which have
economic presence and market sourcing. continued to rely primarily on two of these factors
— property and payroll — to allocate income based
36
on the location of the value-creating activity.
30
Thirty-seven states and the District of Columbia use either a single
sales factor or a heavily weighted sales factor as the general apportionment
formula. Thirty-three states and the District of Columbia use a market-
based sourcing rule to allocate the sales of services. Twenty-nine states and
34
the District of Columbia both rely on a single sales factor or a heavily 7A U.L.A. 91 (UDITPA) (1978).
weighted sales factor and source the sales of services based on market-based 35
sourcing rules (based on COST research). Multistate Tax Compact, Article IV.
31 36
Liz Emanuel and Richard Borean, “When Did Your State Adopt Its The U.S. Supreme Court acknowledged that the three-factor formula
Corporate Income Tax?” Tax Foundation (June 19, 2014). By 1935, 30 has gained wide approval “because payroll, property, and sales appear in
states had adopted corporate income taxes. Id. combination to reflect a very large share of the activities by which value is
32 generated.” Container Corp. of America v. Franchise Tax Board, 463 U.S. 159, 183
See Frieden and Do, supra note 28, at 590-592. During the first two- (1983). The Court noted that such formula “can be justified as a rough,
thirds of the 20th century, state income tax nexus and sourcing rules may practical approximation of the distribution of either a corporation’s sources of
have overlapped with federal and international rules, but this was a income or the social costs which it generates.” General Motors Corp. v. District of
matter of choice, not because the state rules were coupled with federal Columbia, 380 U.S. 553, 561 (1965). For the derivation of the “origin of wealth”
tax law provisions. principle relied on for determining value creation in international tax since the
33
U.S. tax treaties reflecting PE rules generally are not binding on 1920s, see generally Michael J. Graetz and Michael M. O’Hear, “The ‘Original
states. See U.S. Model Income Tax Convention (2016), article 2, para. 3(b). Intent’ of U.S. International Taxation,” 46 Duke L.J. 1021 (1997).
946 TAX NOTES STATE, VOLUME 101, AUGUST 30, 2021
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In the decades that followed, states have District of Columbia generally use a single-
moved gradually but steadily toward assigning sales-factor formula or a formula with a heavily
an even greater share of taxing rights to market weighted sales factor, except for Alaska, Hawaii,
jurisdictions. By 1978, 42 of the 44 states (and the Kansas, Montana, New Mexico, North Dakota,
40
District of Columbia) that imposed a corporate and Oklahoma (see Figure 1).
income tax used the three-factor formula The shift to a single sales factor was one of two
37
adopted by UDITPA and the MTC. By 1994, 17 changes that moved states away from the global
of these states had switched from a single- tax norm of assigning little or no weight to the
weighted to a double-weighted sales factor, thus market itself. The other change occurred in the
allocating half of all income to the market sales factor sourcing rules themselves. From the
38
states. beginning of the development of the UDITPA
Beginning with Iowa in the 1970s, many three-factor formula, sales of tangible personal
states went further and began to rely exclusively property were sourced to the state of destination
on a single sales factor that assigned 100 percent (consumption), thus conforming the sourcing rule
of taxing rights to the market state. In 1978 the with the intent of the sales factor to represent the
41
U.S. Supreme Court affirmed Iowa’s use of a market jurisdiction. However, the original
single-sales-factor formula in Moorman UDITPA and MTC sales factor method provided a
39
Manufacturing Co. v. Bair. As of 2021, nearly all different sourcing rule for “sales, other than
states with a corporate income tax and the tangible personal property” (including services
and intangibles), that attributed these sales
37
Moorman Manufacturing Co. v. Bair, 437 U.S. 267, 283 (1978) (Powell,
J., dissenting).
38
Jamie Bernthal et al., “Single Sales-Factor Corporate Income Tax
Apportionment: Evaluating Impact in Wisconsin,” University of 40
Wisconsin-Madison Workshop in Public Affairs, 18 (May 2012). Based on COST research.
39 41
Moorman, 437 U.S. at 267. UDITPA section 16(a).
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receipts to the state where the income-producing from their use had substantial nexus with the state
activity is performed.42 and thus was subject to the state’s corporate
Many states grew dissatisfied with the income tax laws. Many other states soon followed
functionality of UDITPA’s cost-of-performance Geoffrey’s narrowed application of Quill.
approach because it essentially turned the sales The shift to economic nexus rules initially
factor for sourcing services and intangibles from its focused on businesses that earned income from
intended market approach to something that intangibles (for example, the licensing of trade
mirrored the property and payroll factors. This names or trademarks) or from interstate financial
caused states to move away from UDITPA’s cost-of- services because of the multijurisdictional nature
performance sourcing method to a market-based of these business models, coupled with the lack of
sourcing approach for services and intangibles. The an established physical presence. These early
shift to market sourcing for sales of services and trendsetting shifts to economic nexus for state
intangibles accelerated over the next few decades, income tax purposes were undertaken for the same
spurred on by the growth of the digital economy. reasons that the G-20 and OECD focused on this
Approximately 32 of the 44 states and the District of area 25 years later — concern about the inadequacy
Columbia now generally apply a market-based of exclusive reliance on a physical presence rule in
sourcing rule for service receipts and intangibles — an economy in which physical presence is no
a dramatic increase from the four states that used a longer necessarily a precondition to earning
similar rule just 20 years before.43 significant levels of income in a market jurisdiction.
The State Shift From Physical Presence to In 2018, in Wayfair, a case that received global
Economic Presence Nexus attention, the U.S. Supreme Court overturned its
long-standing physical presence requirement for a
The state corporate income tax shift from a
state to exercise sales tax jurisdiction on a remote
physical presence to an economic presence
seller and replaced it with an economic presence
standard is a more recent historical development,
test.46 Wayfair involved an internet retailer, and the
but still began almost three decades ago. In 1992
44 Supreme Court’s decision rested on the dramatic
the U.S. Supreme Court in Quill reaffirmed its
changes brought about by digital business models.
position that a state could not require a remote
The Wayfair decision, while only applicable to sales
seller to collect sales and use taxes unless the
and use taxes, also had an immediate impact on the
seller had a physical presence in the state.
remaining states that had not yet switched to an
Following the Court’s decision, state courts
economic presence test for corporate income taxes.
wrestled with whether the physical presence rule
Before Wayfair, approximately 15 state courts found
applied to state corporate income taxes. A split
that a physical presence was not required for a state
among state courts emerged, with most state
to impose its corporate income tax. After the Wayfair
courts finding that Quill’s physical presence rule
decision, the shift to economic nexus standards for
did not extend beyond sales and use taxes. This
state corporate income taxes has become universal.
position gained traction in 1993 in Geoffrey,45 in
Now, all states (and the District of Columbia) with a
which the South Carolina Supreme Court held
corporate income tax, except for Delaware, require
that an out-of-state taxpayer that licensed
(or at least do not preclude the use of) an economic
intangibles used in the state and derived income
nexus standard for all business activity (see Figure
47
2).
42
UDITPA section 17. If the income-producing activity is performed
in more than one state, the receipts are attributed to the state in which “a
greater proportion of the income producing activity is performed . . . 46
based on costs of performance.” UDITPA’s three-factor apportionment South Dakota v. Wayfair Inc., 138 S. Ct. 2080 (2018). The physical
method and sourcing rules for sales of services and intangibles based on presence requirement was previously upheld in National Bellas Hess Inc.
the location of the taxpayer’s income-producing activity were also v. Department of Revenue, 386 U.S. 753 (1967), and Quill, 504 U.S. at 298.
47
incorporated in the Multistate Tax Compact in 1967. Based on COST research. The economic nexus standard may be
43
Based on COST research. See generally Frieden and Do, supra note established by broad statutory language, state case law, administrative
28. See also Multistate Tax Compact, Article IV.17(a)(3). guidance affirming the application of an economic presence test or the
44 economic substance doctrine, or through a factor presence test to
Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
45
establish corporate income tax nexus. Some states with broad statutory
Geoffrey Inc. v. South Carolina Tax Commission, 313 S.C. 15, 437 S.E.2d language have offered little to no interpretive guidance on the
13 (1993). application of the standard. See Frieden and Do, supra note 28.
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